Monthly Archives: November 2012

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In response to legislation introduced by Representative Tom Price (R-GA) that would make clear that foreign governments have no authority to tax securities transactions that are between U.S. persons and that occur within the United States, SIFMA released the attached statement of support.

Lofchie Comment: What I find interesting about this is not the tax issue per se, but rather the general question of extra-territorial authority. For example, the EU has recently issued regulations that purport to prevent U.S. persons acting within the United States from entering into short-sale transactions in non-U.S. securities. As I commented in a related news item, this strikes me as an interesting exercise of extra-jurisdictional authority: can a non-U.S. government prohibit a transaction between two U.S. persons even where the subject of the transaction is a security issued by a company based in the jurisdiction of the relevant government? It seems to me that the question of the power to tax is in the same vein: how much authority (whether to prohibit or tax) does a non-U.S. government have as to activities that occur wholly within the United States? I also note that this is not a one-way street. The U.S. CFTC, by way of example, has asserted authority over derivatives where the parties have a very limited connection to the United States; e.g., where a non-U.S. fund that has a single U.S. investor transacts with a non-U.S. bank. So, for all of us who work in financial markets, it will be interesting to see whether we are subject, even within the confines of a single jurisdiction, to more than one leviathan.

Click here to view statement of support (links externally to SIFMA website). I could not find the actual bill introduced by Rep. Price, but will post it when I do find it.

The CFTC issued its first rule specifying the types of swaps required to be cleared by a registered DCO. Under Dodd-Frank, the CFTC is required to determine which swaps must be cleared. The rule represents the first exercise by the CFTC of that authority and applies only to certain credit default swaps (CDS) and interest rate swaps cleared by CME, ICE Clear Credit, ICE Clear Europe and LCH.Clearnet Ltd. Under the rule, market participants will be required to submit a swap that is identified in the rule for clearing by a DCO as soon as technologically practicable and no later than the end of the day of execution.

The rule also specifies the dates by which these products must be cleared. Swap dealers and private funds active in the swaps market will be required to comply with the clearing mandate beginning on March 11. Accounts managed by third-party investment managers as well as ERISA pension plans will have until September 9 to comply. All other financial institutions must comply by June 10. The clearing requirement determination does not apply to those who are eligible to elect an exception from clearing, such as non-financial entities hedging commercial risk nor to swaps entered into prior to the enactment of the Dodd-Frank Act or prior to the application of the clearing requirement.

As we had previously covered in the news, the CME had sued the CFTC over a CFTC “rule” (or interpretation) that would have allowed market participants to select the SDR to which they wished their trade data to be reported without regard to where their trades were cleared. Following the brining of that lawsuit, the CFTC had, without explanation, withdrawn the interpretation in question and also sought comment on a CME Rule that would effectively have allowed the CME to require that trades cleared on the CME be reported to the SDR owned by the CME. Presumably, the withdrawal of the lawsuit constitutes the explanation of the CFTC’s conduct.

Mexico became the third country to sign a FATCA intergovernmental agreement (“IGA”) with the United States on November 19. The Mexican IGA is a reciprocal agreement based on the Model I government-to-government approach under which financial institutions in Mexico will report information required by FATCA to the Mexican government which will automatically forward such information to the U.S. IRS. Annex II to the IGA excludes from FATCA reporting Mexican governmental organizations and insurance institutions for pension and survival as defined in Article 159, fraction IV of the Mexican Social Security Law, as well as certain fideicomisos (Mexican trusts), personal retirement plans, Mandatory Savings administered by the Mexican Retirement Administration and voluntary and Complementary Savings administered by the Mexican Retirement Funds Administrators.

Michael Pettis is known as one of the most astute observers of the Chinese economy. He is Professor of Finance at Guanghua School of Management, Peking University. In the November 12 issue of his China Financial Markets newsletter (link is to his related Web site, not to the newsletter itself), he writes these reflections on The Bretton Woods Transcripts:

For those who are interested in this sort of thing (and I confess I most certainly am), transcripts of the Bretton Woods conference in 1944 have recently been discovered and are being published on Kindle.

…One part of the debates that I found especially interesting was a debate on workers’ remittances. The USSR had insisted during the meetings that workers remittances be included in the capital account, and so subject to capital controls. Several other countries, led by China, were opposed. The latter won the debate, and today, of course, workers’ remittances are included in the current account.

Among other things this shows just how wobbly some of the capital account/current account distinctions are. I think from a political point of view workers’ remittances should certainly not be subject to capital controls, but otherwise I think conceptually they really belong in the capital account, although because they tend to be countercyclical there certainly are good reasons for suggesting that they should be treated differently from other items in the capital account. I would also argue that interest payments and dividends, which are today part of the current account, should be part of the capital account although again, because they are nominally fixed and not subject to changes in investor sentiment, perhaps they don’t fit wholly comfortably in the capital account.

Federal Reserve Governor Daniel Tarullo gave a speech discussing what he termed a “practical and reasonable way forward” in the U.S. regulation of foreign banking organizations. Tarullo noted that the profile of foreign bank operations in the United States changed significantly in the run-up to the financial crisis (see also attached study), shifting from a “lending branch” model to a “funding branch” model, in which U.S. branches of foreign banks began borrowing large amounts of U.S. dollars “to upstream to their parents.” The financial crisis, Tarullo argued, has served to reveal the financial stability risks associated with the foreign banking model as it has evolved in the United States. One of these dangers, Tarullo noted, is that a global bank’s capital and liquidity can end up “trapped at the home entity” in the event of a failure.

Tarullo stated that as a result of the changes in the activities of foreign banks and the risks attendant to those changes, regulators will need to adjust the regimes applicable to foreign banks. In particular, Tarullo outlined the following prospective changes:

A “more uniform structure” for the largest U.S. operations of foreign banks, which would require that they establish a top-tier U.S. intermediate holding company (an “IHC”) over all U.S. bank and non-bank subsidiaries. Tarullo argued that this would allow for more consistent supervision across foreign banks, and would also reduce the ability of foreign banks to avoid U.S. consolidated-capital regulations.

The same capital rules applicable to U.S. BHCs should also apply to U.S. IHCs.

There should be liquidity standards for large U.S. operations of foreign banks. For IHCs, the standards would be “broadly consistent with the standards the Federal Reserve has proposed for large domestic BHCs.”

Tarullo noted that the Fed expects to issue a notice of proposed rulemaking in line with the basic approach outlined above “in the coming weeks.”

Lofchie Comment: Governor Tarullo suggests a radical change in the manner in which the U.S. operations of non-U.S. banks are regulated from (i) our current regime in which U.S. bank regulators largely defer to home country regulators to (ii) a new regime in which the U.S. regulators would assume a substantial degree of control over the U.S. operations of non-U.S. banks, including potentially requiring non-U.S. banks having bank and corporate subsidiaries in the United States to be part of a separate mid-tier subsidiary referred to as an IHC. Essentially, the IHC would be regulated as a U.S. bank holding company. The U.S. branches of non-U.S. banks would also be subject to additional regulation, although perhaps not as great as that applicable to separate subsidiaries. Governor Tarullo provides a number of reasons as to why such a shift in U.S. policy is required including the following: (i) non-U.S. banks have become net borrowers in the United States, rather than net lenders to the United States (see footnote 12 of the speech); (ii) during the financial crisis, non-U.S. banks were directly supported by the Fed (as well as their home country regulators); (iii) in a future financial crisis, Governor Tarullo believes that non-U.S. governments may be less willing or able to support the U.S. branches of their home country banks, thus increasing their potential need for support from the Fed or the potential that their failure disrupts the U.S. economy; and (iv) non-U.S. banking organizations play a major role in the U.S. banking and securities markets (23 foreign banks with $50 billion in assets in the U.S. as compared to 25 U.S. banking organizations of such size in the United States; likewise, five of the top ten securities firms in the United States are subsidiaries of non-U.S. organizations). I do not know whether the legislative and regulatory changes suggested by Governor Tarullo are on the same scale in their impact as those mandated by Dodd-Frank; if they are not, they are not far off. He is suggesting a very substantial re-thinking of the manner in which global financial institutions are regulated, so that host country regulation is emphasized over home country regulation. To return to the comparison with Dodd-Frank, this proposal would also entail, I think, some substantial re-thinking of portions of Dodd-Frank, such as Lincoln and Volcker, insofar as they apply to non-U.S. banks.

The CFTC issued its first rule specifying the types of swaps required to be cleared. The swaps that will be subject to mandatory clearing are two classes of untranched index credit default swaps (CDS) and four classes of interest rate swaps relating to four currencies (U.S. dollars, British pounds, euros and Japanese yen). The clearing requirement determination applies to swaps currently cleared by four DCOs: CME, ICE Clear Credit, ICE Clear Europe, and LCH.Clearnet Ltd. The attached press release provides a fuller description of the swaps that will be subject to mandatory clearing.

According to the attached FAQ, the earliest date by which clearing requirements will be effective for any entities is March 11, 2013 for so-called Category 1 entities. (Category 2 Entities will be subject to clearing on June 10, 2013, and everyone else on September 9, 2013.) Clearing requirements will not be applied retroactively for swaps entered into before any of such dates.

The CFTC Division of Clearing and Risk (DCR) announced the issuance of two time-limited, no-action letters granting relief from required clearing under Section 2(h)(1)(A) of the Commodity Exchange Act and the Commission’s newly adopted Part 50 regulations for certain swaps entered into by either qualifying affiliated counterparties or qualifying cooperatives.

Affiliate Letter. The no-action letter provides that DCR will not recommend an enforcement action for failure to clear a swap entered into by affiliated counterparties if one of the counterparties to the swap is majority owned by the other counterparty or both counterparties are majority owned by a third party and the financial statements of both counterparties and the third-party majority owner, if any, are reported for accounting purposes on a consolidated basis. In addition, both affiliates must agree not to clear the swap. On August 21, 2012, the Commission published for public comment in the Federal Register a notice of proposed rulemaking to exempt swaps between two affiliated counterparties from required clearing.

Co-operative Letter: The no-action letter provides that DCR will not recommend an enforcement action for failure to clear a swap entered into by a cooperative if the cooperative and the swap meet certain conditions set forth in the no-action letter. To qualify for the no-action relief, one of the counterparties to the swap must be a cooperative whose members are either non-financial entities or cooperatives whose members are non-financial entities. In addition, the no-action relief only applies to swaps entered into in connection with originating loans to cooperative members or that are related to loans to, or swaps with, members. The conditions are substantially similar to the conditions included in the proposed cooperative exemption rule published by the Commission in the Federal Register on July 17, 2012.

The no-action relief will remain in effect until the earlier of April 1, 2013, or the effective date of a Commission rulemaking finalizing the proposed inter-affiliate clearing exemption rule, or the proposed qualifying cooperative exemption rule, respectively.

CFTC Letter 12-35: Section 2(h) of the CEA; Time-Limited No-Action Relief from the Clearing Requirement for Swaps between Affiliated Counterparties.CFTC Letter 12-36: Section 2(h) of the CEA; Time-Limited No-Action Relief from the Clearing Requirement for Swaps Entered into by Cooperatives.

MFA submitted the attached supplemental comment letter to the U.S. prudential regulators during the reopened comment period for their proposed rulemaking on “Margin and Capital Requirements for Covered Swap Entities” in which it sets forth the following six positions:

Internationally uniform margin requirements;

A single compliance date for the final margin rules for all uncleared swaps for all market participants;

MFA appended its accompanying portfolio margining letter to advocate for the continued use of portfolio margining arrangements across suitably correlated cleared products and non-cleared swaps in a buy-side firm’s portfolio that are subject to a cross-product master netting agreement;

Requiring dealers to provide a transparent model for determining initial margin (though dealers could collect more margin from a less creditworthy counterparty); and

MFA urged the prudential regulators to adopt risk-based margin requirements that are appropriately tailored to address the risks posed by the relevant non-cleared swap transaction, which MFA argues would have the effect of substantially lowering initial margin requirements for reasons including that the regulators have overstated the time necessary to liquidate uncleared swap positions.

SIFMA submitted a letter, dated November 26, 2012, to the various U.S. banking regulators to which SIFMA appended a prior letter, dated September 28, 2012, to the Basel banking regulators, in each case concerning margin requirements. The very short letter to the U.S. banking regulators thanks the banking regulators for reopening the comment period on the banking regulators’ margin rule for swaps and also asked that, if the banking regulators materially amend their proposed margin rules for swaps, that the revised rule be reissued as a proposal for public comment, rather than being simply adopted.

The much longer September letter to the Basel regulators provides a full commentary on proposed margin requirements issued in a Basel/IOSCO consultation paper. Notably, the September letter supports a limited requirement of two-way transfer of variation margin between financial counterparties. However, it opposes a number of other suggestions in the consultation paper including the mandated posting of initial margin on uncleared swaps by regulated financial institutions.

Click here to view comments in full (links externally to SIFMA website).